Question

How to find the price of a preferred stock? give 2 examples

Answer 1

Preferred Stock are a type of securities that combine some feature of common stock with some features of corporate bonds. It is a hybrid security which can be used as another long term source of finance for a concern.Certain features of preferred stock are as stated below:

• Technically, these stocks are equity securities but have features of debt instruments as they have consistent dividend rights with no voting powers.
• Preferred stockholders are paid dividend in priority to common shareholders, and enjoy preferential claim on the assets of the company in the event of liquidation.But they are not superiors to bond holders.

As a result of the above features, dividend valuation models should be used to price preferred stocks.

i) If dividends are fixed:

Step1: Discount each year dividend by the required rate of return to find the present values.

Step2: Adding all the present values of the dividends to give the total which is the value of the preferred stock.

Example- XYZ Ltd pays 25% monthly dividend to preferred stockholders with Face value $ 1. Required rate of return is 5%.So usind dividend discount model value=

V= D₁/(1+r)+D₂/(1+r²)....+ D_n/(1+rⁿ) where D1= dividend for next year r= required rate of return.

As dividends are same V=D/r or, $3/0.05=$ 60

ii) If dividends are growing:

If there is a constant growth in dividends then Gordon's Growth Model can be used to determine the value.

V= D/(r-g) where D is dividend, r= required rate of return and g= growth rate of dividends.

Example: XYZ Ltd pays dividend of $3 per year. Dividend has a constant growth rate of 3%.ROR=5%

Then, V= $3/(0.05-0.03)=$150